Edmond Jackson's Stockwatch: Why Buffett is wrong on Tesco

Among the trickiest areas of investment is whether to exit shares in well-established companies facing tough conditions. You neither want to succumb to market sentiment nor bury your head in the sand. Mind how the 30-year history of the FTSE 100 (UKX) index involves only 30 of the original companies: business is dynamic and there is also opportunity cost to consider: might your money be better protected elsewhere?

Many shareholders have hung on to Tesco because its original membership of the Footsie implies long-term resilience; and at about 275p a share currently the prospective yield looks to be 5.4%, covered 1.5 times by forecast earnings; also Warren Buffett's Berkshire Hathaway Inc owns 4%, i.e. nearly £1 billion exposure even as the shares fathom chart lows. But I think he has made a serious mistake in departing from his principles.

Firstly there is no "economic moat" surrounding Tesco or, indeed, any of the big four UK supermarket groups. This sector is intensely competitive and shareholder value can only be achieved by two means: under-cutting on price, as Aldi and Lidl are doing by astute sourcing; also differentiating the brand, which accounts for Waitrose's success despite its generally higher prices. Sainsbury's goes some of the way, also Asda. But Tesco and Morrisons are groping to attract customers, ceding margin so as not to keep losing them to the discounters.

"Margin of safety"

Tesco has had some success introducing "Metro" convenience stores, but tough decisions are needed over the out-of-town superstores which are becoming white elephants. It implies substantial exceptional costs in the next two years as a new chief executive tries to redefine strategy and take necessary hits. A key reason why Tesco's share price continues to fall is its dividend yield needing to rise to compensate for this and other risks.

Secondly, Tesco does not possess "franchise value" by which Buffett means enduring strength of brand where customers believe there is no close substitute. Presumably he saw international potential, but Tesco's expansion has seen overall disappointment as its US Fresh & Easy chain filed for bankruptcy last October and other overseas operations have struggled. At least two-thirds of turnover is UK-derived where management faces a considerable challenge to refresh the stores' appeal.

Thirdly, there is no "margin of safety" between the market price of Tesco shares and their intrinsic value. Buffett usually implores this cornerstone principle of Benjamin Graham, the 20th century father of value investing; but even after Tesco's five-year chart shows a price decline from 450p it is hard to define any such margin. Net tangible assets per share have slipped from 164p to 135p in the last two financial years and look liable to go lower with write-downs. Mind that the consensus for about £2.1 billion normalised pre-tax profit is at risk with the latest trading update indicating a "weaker" overall market and sales/profit below expectations, i.e. the forward price/earnings (P/E) multiple may be higher than 13 as recent forecasts implied.

Risky for income investors

There is a case for high P/E's applying in recovery situations where the business is strong but experiencing short-term difficulties; but Tesco's problems are big and cumbersome to resolve now the UK has plenty of supermarkets; any turnaround looks a three to five-year challenge. The potential saving grace is a strong cash flow profile in support of the dividend (see table); but until the new chief executive has settled in and defined a new strategy, Tesco is risky for income investors; even a 5% yield is easily offset by share price erosion, if write-downs lurk.

The major UK supermarkets are getting just desserts after an attempt to hike food prices during the recessionary years backfired, as discounters took advantage and more people discovered Aldi, Lidl and Poundland (PLND). Their appeal is not just low prices: Lidl for example has been endorsed for its Christmas pudding and a recent panel recommended its wine; coverage which will attract new customers as it embarks on a £220 million UK store expansion programme; and Aldi is similarly set to spend £600 million. These privately-owned operators are also in a stronger position to expand without the worry about near-term earnings and dividends.

No chart-oriented investor or trader would currently want to hold Tesco, whose chart says plenty. Eventually a resistance point will kick in, similarly as Easyjet and Ryanair have not put British Airways out of business, but these are early days to speculate on turnaround.

Whether the departing boss gains £10 million or £26 million according to reports, it is another sign how Tesco is disconnected - big mistakes meaning massive rewards. Despite their salaries the Tesco top brass make ridiculously small share purchases via a "partnership share scheme": e.g. the chief executive (and others) last bought 39 shares and the contrast with the pay-off makes a farce of corporate governance.

Leave this organisation time to sort itself out.

For more information see www.tescoplc.com